By: Drew Boyce (firstname.lastname@example.org)
In the natural gas market, every molecule you produce or consume is bought or sold at an exact location. Linking that location to a quoted mark in a Published Index for pricing and hedging purposes is not always as straightforward. As a producer or consumer, the goal should be to find the index that best suits desired price exposure and hedging strategy.
Over time, the natural gas market has evolved. Often, published indices have not. Take Perryville, an area in northeastern Louisiana, where interstate pipelines connect to carry supply from producing basins downstream to end user markets. Perryville has become a major physical trading hub. But it does not have an index of its own.
When transacting at Perryville, the price received or paid could be linked to numerous indices which could each have notable premiums or discounts. Depending on factors upstream and downstream of Perryville, these premiums and discounts can also have significant month-to-month variability. These pricing dynamics cause correlation volatility, which can materially impact a risk management strategy. Additionally, month-to-month changes in premiums and discounts can significantly affect the value of transportation to or from Perryville. If not properly executed, physical trades in this area can result in payouts on a derivative position without offsetting physical revenue/costs, and/or flip transportation rights from being an asset to a liability.
Beyond the complexities at a given location, there are also multiple price reporting publications, though Inside FERC is most often used. Inside FERC and the other varied price reporting entities attempt to provide as much granularity as possible. But there are liquidity issues that limit the ability to publish prices for all physical locations across the U.S. Regardless of the publication, there are two primary causes of physical location price risk. Either a given location does not have a published index price, or a given location is one of many included in a published index. It is critical to understand the risk associated with how the market discounts or places a premium on your specific location, and how market conditions can cause historical relationships to change. Supply and demand fundamentals, newly added pricing locations, regional storage balances, and changes to pipeline infrastructure are some of the obvious factors that can impact how your physical location prices.
In theory, the only limitation to how molecules can be priced is derived from your counterparty’s willingness to trade at varying locations. However, choosing the “right” location must take into account risk tolerance, which then requires an understanding of and inclusion into your financial risk management strategy. When determining which index price is ideal, it’s important to simultaneously weigh the benefits and risks associated with that choice, as well as how financial and physical market factors may not always fall on the same side of the cost/benefit ledger. These decisions must also be inclusive of owned transport, and when considering the acquisition of new transport, the same analysis must be applied. If efficiently designed and managed, the sale or purchase of MMBtus will at a minimum leave management teams with few surprises, and ideally create a cost-effective risk mitigation process.
Conceptually, to avoid all locational price risk, financial and physical transactions must be executed simultaneously and linked to the same index price. That said, it is often unrealistic or inefficient to hedge 100% of a position financially 3 to 4 years out and concurrently pair that trade with a physical transaction without incurring punitive execution costs. Parties responsible for financial risk management and physical marketing/procurement must act in concert to efficiently minimize risk. This concept applies equally to term, seasonal, and monthly exposure. The physical marketing/procurement must A) execute at the same indices that the financial team has previously hedged B) clearly communicate the value of trading at an alternate index price, with stated risks defined as clearly as possible, or C) collaboratively work with the financial risk management team to determine the most efficient manner (physical/financial) in which to re-orient towards another location when market conditions warrant.
There are countless examples of how physical location price risks can significantly impact realized pricing. Unfortunately for many producers and consumers, a breakdown in the communication of strategy, and actions taken per said plan, are often not fully understood until after the accounting process is complete. To avoid being in a constant state of post-mortem discovery on deviations from plan, it is imperative that a cohesive, dynamic, and measurable strategy include all facets of the execution and reporting process.